Sunday, October 14, 2007

Inflation, like its cousin deflation, is usually seen as an economic bogeyman with the potential to wreak economic havoc if it runs out of control.

AS RECENTLY as four years ago, it was the fear of falling consumer prices and its corrosive effect on the stock market and residential properties which gave investors sleepless nights.

Now, economists are worrying about the very opposite phenomenon - rising levels of inflation and their impact on the global economy.

Inflation, like its cousin deflation, is usually seen as an economic bogeyman with the potential to wreak economic havoc if it runs out of control.

But there are circumstances under which investors - property buyers for instance - can win from rising consumer prices.

First, think back to 2003, when Sars stalked much of East Asia and the deflation beast was on the loose. Buying sentiment was so poor that even though residential property prices plummeted, there were few takers.

Downward spiral

AND nearly every condo owner had a grim tale or two to tell of the blight on their posh estates - when, say, an unfortunate neighbour’s flat was repossessed by the bank and put up for mortgagee sale, after he had defaulted on his mortgage.

Such scenarios often turn into a downward spiral. The more buyers postpone purchases, the more sellers are forced to cut prices.

Deflation becomes the enemy of the borrower saddled with huge debts.

Even though he might have borrowed at a 1 per cent interest rate from the bank, if the price of his property falls by 5 per cent, he is actually paying 6 per cent rates in real terms.

Worse, he may suffer negative equity, as the value of his home slips below the amount owed on the mortgage.

In practice, this type of nasty economic downward spiral works like a massive dampener on the stock market too. From 2000 to 2002, the benchmark Straits Times Index ended lower each year for three consecutive years.

Fast forward to now, and the scenario could hardly be more different. Property prices are soaring and there is an air of growing prosperity.

The main gripe now is about how expensive condos are and how much extra cash is needed to fill up the car’s petrol tank, as inflation climbs.

Those old enough to have lived through the tumultuous 1970s, when inflation was in double digits, warn that too much inflation is a bad thing.

Then, like right now, inflation was unleashed by a lethal cocktail of rocketing oil prices and low interest rate policies by successive United States Federal Reserve chairmen, which caused prices of goods to surge, even as the global economy wallowed in recession.

But those looking back at the 1970s also observed that the era provided ample opportunities for great fortunes to be created.

Overall, the stock market performance back then was decidedly unimpressive.

After hitting record highs in 1972, blue chips such as OCBC Bank and United Overseas Bank sank to a fraction of their values, as a gigantic stock market bubble burst with the onset of rampant inflation, after oil prices quadrupled.

But in Singapore and Hong Kong, this also created an environment where interest rates on loans became effectively negative, as inflation galloped ahead of mortgage rates.

In other words, paying off a loan with 5 per cent interest was a breeze if, for instance, prices - and presumably wages - were rising at 7 or 8 per cent year.

Those who took out big loans to finance real estate purchases in Singapore and Hong Kong, where prime land was in scarce supply, were amply rewarded for taking the risks.

Inflation eroded the costs of their borrowings, while providing the perfect backdrop for soaring property prices.

This spawned a new generation of billionaires such as Hong Kong’s Li Ka Shing and the Hong Leong group’s late patriarch Kwek Hong Png, as they rode the property bubble caused by worldwide stagflation - inflation coupled with stagnant economies - to create massive business empires.

It is too early to say whether the world is on the verge of entering a scenario like that seen in the 1970s, which wrought havoc in global economies but also richly rewarded the few who were fortuitous enough to recognise how they might profit from it.

But one thing is certain. Inflation is here to stay, as long as oil prices continue to stay at their current sky-high levels of above US$80 a barrel.

Negative interest

AND with the Fed bowing to domestic pressure by cutting interest rates to combat a souring mortgage crisis back home, prices of prime assets such as Singapore real estate may go on a roll, as funds flee from the falling returns offered by a weakening dollar.

So just like in the 1970s, home owners may get to enjoy effective negative interest rates once again, as their home prices appreciate well above the servicing costs on their mortgages.

For a young couple just starting out in life, the best bet is to get married early and apply for a new HDB flat.

Although they will have to slog to pay back the enormous home loan they take out, it will be the best insurance they can take out to protect their Central Provident Fund life savings from being eroded over the years by inflation.

The odds are good that, like their parents before them, they will stand to reap huge capital gains, as property prices swing up.

Inflation can pose some serious economic headaches if it begins to run out of control, as it can create major uncertainty throughout an economy. People on fixed salaries suffer badly too.

But for some investors at least, inflation can represent a happy problem to live with, at least for now.

As one economist observes, the opposite of inflation - deflation - is like quicksand, easy to get stuck in, but difficult to escape.

Inflation may have its problems but, for some, it can be turned into fabulous investment opportunities.